Capital Structure Theories and Financial Growth Circle Model

By John Dudovskiy

capital structure The capital structure model was promoted by Modigliani and Miller (also known as MM) (1958) which indicated that the value of the company is unchanged by the alternative mix of capital structure, namely the structure of the capital is irrelevant to the value of the firm assuming that no tax and all profit are apportioned as dividends. However, Gray et al (2007) stated that such a perfect capital market does not exist in real life.

Jensen and Meckling’s (1976) (cited in Gregory et al, 2005) agency theory provides insight into the financial management of capital structure  where it states that a contract is made where a principal (owner) hires and agent (directors) to run the company on their behalf by delegating the responsibilities and pays them for it. However, in the case of SMEs, majority directors of the businesses are owners of them too.

Cassar and Holmes (2003) mentioned about the pecking order model by (Myers, 1984), which suggests that firms have a particular preference order to finance their businesses. He indicated that due to the information asymmetry between the firm and the potential investors, the agents (managers) know more about the firm, its potential value and future prospects than the new investors.  Therefore, managers know what form of financing is available to the business at any given stage. From this point of view managers usually try to obtain the financing that they think is obtainable for them. This sometimes leads to a situation where managers have not tried other available sources of financing as they assumed that the source of finance they obtained has been the best and only choice for them.

Many researchers have researched the capital structure decision form the perspectives of small firms (Gregory et al, 2005, Cassar and Holmes, 2003, Coleman, 1998, Berger and Udell, 1996 and many others). This is due to the fact that problems related to financing normally arise predominantly in small businesses due to inadequate financial resources both in their start-up and growth stages.

One of the most famous models proposed was undertaken by Berger and Udell (1998) where they proposed that small businesses have a financial growth cycle in which financial needs and options change over time. They further stated that financial needs of the firm are also dependent on the size and age of their operations. When they are young and small, they usually rely on initial finance such as personal savings and borrowing from friends and family.

When they reach to growth stage, they will get an access to intermediated finance which can be both in the form of equity and loan. When they get even bigger and older, they will gain an access to public equity and debt markets. They further pointed out to the fact that the growth cycle is not always intended to fit all small firms.

 References

  • Cassar, G., & Holmes, S. (2003), “Capital structure and financing of SMEs: Australian evidence”, Accounting and Finance Vol. 43
  • Berger, A. N. and Udell, G.F. (1998), “The economics of small business finance: The role  of  private  equity  and  debt  markets  in  the  finance  growth  cycle”,  Journal  of Banking and Finance, Vol.22, No. 6–8
  • Gregory, B.T., Rutherford, M.W., Oswald, S. and Gardiner, L. (2005), “An empirical investigation of  the  growth  cycle  theory  of  small  firm  financing”,  Journal of Small Business Management, Vol. 43, No. 4
  • Jensen, M. and Meckling, W. (1976), “Theory of the firm: managerial behaviour, agency costs and ownership structure”, Journal of Financial Economics, Vol. 3, pp305–360
  • Mayers, S.C. (1984), “The capital structure puzzle”, The Journal of Finance, Vol. 39 No.3
Category: Finance
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